further, it shows you the behavior of option premium with respect to change in
volatility and the number of days to expiry.
Have a look at the first chart (CE), the blue line represents the change in premium
with respect to change in volatility when there is 30 days left for expiry, likewise the
green and red line represents the change in premium with respect to change in
volatility when there is 15 days left and 5 days left for expiry respectively.
Keeping this in perspective, here are a few observations (observations are common
for both Call and Put options) –
1. Referring to the Blue line – when there are 30 days left for expiry (start of the series)
and the volatility increases from 15% to 30%, the premium increases from 97 to 190,
representing about 95.5% change in premium
2. Referring to the Green line – when there are 15 days left for expiry (mid series) and
the volatility increases from 15% to 30%, the premium increases from 67 to 100,
representing about 50% change in premium
3. Referring to the Red line – when there are 5 days left for expiry (towards the end of
series) and the volatility increases from 15% to 30%, the premium increases from 38
to 56, representing about 47% change in premium
Keeping the above observations in perspective, we can make few deductions –
1. The graphs above considers a 100% increase of volatility from 15% to 30% and its
effect on the premiums. The idea is to capture and understand the behavior of
increase in volatility with respect to premium and time. Please be aware that
observations hold true even if the volatility moves by smaller amounts like maybe
20% or 30%, its just that the respective move in the premium will be proportional
2. The effect of Increase in volatility is maximum when there are more days to expiry –
this means if you are at the start of series, and the volatility is high then you know
premiums are plum. Maybe a good idea to write these options and collect the
premiums – invariably when volatility cools off, the premiums also cool off and you
could pocket the differential in premium
3. When there are few days to expiry and the volatility shoots up the premiums also
goes up, but not as much as it would when there are more days left for expiry. So if
you are a wondering why your long options are not working favorably in a highly
volatile environment, make sure you look at the time to expiry
So at this point one thing is clear – with increase in volatility, the premiums increase,
but the question is ‘by how much?’. This is exactly what the Vega tells us.
The Vega of an option measures the rate of change of option’s value (premium) with
every percentage change in volatility. Since options gain value with increase in
volatility, the vega is a positive number, for both calls and puts. For example – if the
option has a vega of 0.15, then for each % change in volatility, the option will gain or
lose 0.15 in its theoretical value.